Varonis Systems Q3 2023 Earnings Call Transcript

Quartr
Provided by Quartr
October 30, 2023

There are 13 speakers on the call.

Operator

Greetings, and welcome to Varonis Systems Inc. Third Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen only mode. A question and answer session will follow the formal presentation. As a reminder, this conference is being recorded.

Operator

It is now my pleasure to introduce Tim Purse, Investor Relations. Thank you. You may begin. Thank you, operator. Good afternoon.

Operator

Thank you for joining us today to review Varonis' 3rd quarter Sir, and Chief Operating Officer of Varonis. After preliminary remarks, we will open the call to a question and answer session. During this call, we may make statements related to our business that would be considered forward looking statements under federal securities laws, including projections of future operating results for our Q4 and full year ending December 31, 2023. Due to a number of factors, actual results may differ materially from those set forth in such statements. These factors are set forth in the earnings press release That we issued today under the section captioned Forward Looking Statements and these and other important risk factors are described more fully in our reports filed with the Securities and We encourage all investors to read our SEC filings.

Operator

These statements reflect our views Only as of today and should not be relied upon as representing our views as of any subsequent date. Varonis expressly disclaims any application or undertaking Financial measures will be discussed on this conference call. A reconciliation for the most directly comparable GAAP financial measures It's also available in our Q3 2023 earnings press release and investor presentation, which can be found at www.avaronis. Lastly, please note that a webcast of today's call is available on our website in the Investor Relations section. With that, I'd like to turn the call over to our Chief Executive Officer, Jaki Teitelsson.

Operator

Jaki?

Speaker 1

Thanks, team, and good afternoon, everyone. Thank you for joining us today. Let me start by saying our thoughts With our employees, customers, partners and all of those impacted by the recent events in Israel, we will continue To do whatever it takes to support our employees, today, I would like to review our Q3 results and discuss how AI can serve as a meaningful tailwind to our business in the years to come. But first, I would like to remind you why Varonis exists And the problems we solve, data is the prime target for bad actors because of its importance to a business. Data is also out of control.

Speaker 1

The explosion of the cloud and remote work has improved collaboration, but has also Made securing data more difficult, Varonis helps companies locate sensitive data, visualize who has access to it It automatically lock you down. This allows companies to collaborate safely and get value from their data While managing risk and AI, we only make this an even greater priority. Our 3rd quarter results Reflect the continued healthy adoption of Varonis SaaS. We saw further evidence that our transition The SaaS business model is working and SaaS ARR now represent approximately 15% of total company ARR. 3rd quarter SaaS mix came in at 59%, comfortably ahead of our guidance of 45%.

Speaker 1

ARs was 16% year over year to $517,500,000 and we have generated $46,000,000 The free cash flow year to date up from $800,000 for the same period last year. Guy will review our Q3 results and our updated guidance in more detail. From a macro standpoint, we continue to see high level of deal Now, I would like to spend some time on how AI presents a meaningful opportunity for Varonis. In my conversation with customers and prospects, AI comes up more and more. And my key takeaway for Varonis Given the growth of AI, there's the potential to generate significantly more data, significantly more risk and significantly increase the need Stepping back, generative AI presents both opportunity and risk for companies.

Speaker 1

It has an opportunity to boost productivity and efficiency, but in order to safely realize these benefits, There are security risks that businesses must mitigate first. These risks present opportunities for companies like Varonis. The first risk is related to what I call self inflicted risk, Which happens when businesses start using AI to suggest content to employees. Unless data is locked down, There is little to prevent AI from analyzing the company's entire data estate and revealing critical business assets The customer lists, payroll files or bank account information to the wrong people. Microsoft recommends Mitigating this risk by securing sensitive data before deploying Copilot, which is the company's AI assistant, And specifically, recommend having the right information, access controls and policies in place.

Speaker 1

This is precisely what Varonis does. Without Varonis, rightsizing access control is very challenging. Managing access control only gets harder over time With the data spot and AI will surely contribute further to this problem. Without the right control in place, AI doesn't know Who should see what and surface everything for everyone. This becomes a huge risk Organizations and best actors won't even need to search for content they want to steal, AI will help them to find it automatically.

Speaker 1

AI will also increase the risk that companies face from external attackers. A few examples of this include Helping bad actors create and translate phishing emails, so they can use them in many languages, Creating fake data sets in order to trick companies into paying ransoms and creating models. Unfortunately, the use of AI will continue to lower the barriers to entry for hacking nor is helps organizations mitigate this risk By ensuring that only the right people have access to the information that they need to do their job, Varonis can help organizations ensure that employees only see Content suggestions that are relevant to their job function. If a bad actor bypass perimeter controls, Varonis can lock out The compromised users or machine preventing damage from happening. Although it is early and we are still quantifying timing and sizing, We see AI becoming a growth tailwind to our business as it gains momentum and has detailed plans to execute.

Speaker 1

Apart from demand opportunity that we see arising from security risk related to AI, we are also leveraging this technology In new ways to improve our customer experience, Varonis has been using machine learning and AI for many years In our analysis engine and threat model, for example, and today we are announcing 2 exciting generative AI capabilities In our SaaS data security platform, AI System Security Operations Center or what we call SOC and Natural Language Search. Although we do not plan to sell AI as a separate SKU, our AI assistant SOC will provide security analysts is an intelligent AI system specialized in performing investigation, remediating threats and proactively Our SaaS platform can analyze alerts and provide context and next steps To help analysts more efficiently resolve security incidents. With natural language search, AI makes every voice user a power user. Anyone from the help desk to CECL can use natural language to get fast and accurate answers to questions such as, Do we have any files containing passwords that are exposed to everyone on the Internet? Or what users have been accessing our payroll files?

Speaker 1

Today, newly introduced generative AI features build upon the Veronese SaaS benefits As we have discussed with you over the past year and we further reduce the time to value Our customers and improve their experience with Vons. I would like to spend a moment to remind you of the 3 key benefits of SaaS platform provides our customers. First, customers are much better protected with much less effort with automated remediation and proactive incident response. 2nd, SaaS is quicker to deploy and significantly lower infrastructure cost. And third, SaaS is easier to maintain and upgrade.

Speaker 1

3 of the key benefits that we realize are 1, shorter sales cycle 2, larger initial length and 3, Margin benefits over time. This quarter, we continue to see additional proof points of these benefits. A large state government organization We became a Voronie SaaS customer this quarter. We first gained a department of this state As a customer in 2022, over the past year, we had a very successful deployment with the department that allowed us To build credibility and ultimately win the broader state government mandate. For this organization, SaaS, was a must have Because the security team is straight to think, now they will benefit from quicker time to value, Faster deployment and most importantly, they will be better protected with our proactive incident response team And automated remediation for Windows On Prem and Microsoft 365.

Speaker 1

We also continue to see Healthy interest from existing self hosted customers who converted to SaaS this quarter. One example was a multinational financial that first became a customer in 2020, given the large volume of sensitive customer data, This organization's success protecting on prem Windows drove a desire To consume all of the platform by going both wider and deeper, VeronisAS will now help them shrink their blast radius In the cloud, just as they did on plan, proactive incident response We supplement those early detection capabilities and Veron E SaaS eliminates the need for this customer to manage their own hardware, which will improve their scalability. We converted their on prem Windows licenses into SaaS equivalent package In the purchase and additional SaaS package for Microsoft 365, widening their coverage. The sustained momentum that we saw from our SaaS transition this quarter, coupled with our faster pace of innovation Get us closer to achieving a $1,000,000,000 ARR target and delivering meaningful stakeholder value. With that, let me turn the call over to Guy.

Speaker 1

Guy?

Speaker 2

Thanks, Yaki. Good afternoon, everyone. Thank you for joining us today. It goes without saying that the health and safety of our employees is of paramount importance to us and we will continue to do whatever it takes to support them. Before I discuss results, I want to briefly comment on the impact of the war in Israel on our operations.

Speaker 2

From a top line perspective, Israel has historically represented less than 1% of our business. We have approximately a third of our employees located in Israel, which includes our principal research and development facility, as well as a portion of our support and general and administrative team. At this time, a low single digit percentage of our global team members have been called up to active duty. We have executed business contingency plans to minimize the impact on our business. And at this time, we don't expect a material impact on our global operations.

Speaker 2

With that, I'd like to turn to Q3 results. We are pleased with the continued strong adoption of Veronese SaaS against continued macro headwinds. Our SaaS transition continues to gain momentum and this quarter provided additional proof of the numerous benefits to our customers as well as the tailwind to our ARR and cash flow performance. As a reminder, ARR free cash flow and ARR contribution margin 80% of the deal's value is recognized upfront to a SaaS model with fully ratable revenue recognition We'll cause initial headwinds on the traditional income statement metrics as the SaaS mix and conversions of existing customers to SaaS increase. And this quarter's impact was meaningful as the number of existing customers converting to SaaS again increased.

Speaker 2

However, these headwinds are a function of accounting treatment and are not indicative of the health of our business. In fact, the greater these accounting related headwinds are, the better it is for our business as it means the transition is progressing at a faster pace. Our 3rd quarter SaaS mix represented 59% of new business and net new upsell ARR This is our guidance of 45% and after only 3 quarters into the transition, SaaS now represents Approximately 15% of the company's total ARR, the average deal sizes realized in Q3 Continue to provide us with confidence in the 25% to 30% pricing uplift and margin structure that we previously provided. In the Q3, a significant amount of SaaS deals were sold to new customers, but we again saw an increase in existing customers converting Our SaaS offering. In the Q3, we had approximately $10,000,000 in conversions of existing customers, Impacting our Q3 revenue.

Speaker 2

To be clear, this is the renewal amount that was previously booked as an on prem subscription that is now SaaS, which causes a headwind to our reported revenue and operating margin, but does not impact ARR or free cash flow. The $10,000,000 from this quarter does not include the uplift that we realized from these conversions, which is accretive to ARR and free cash flow. As we look to our revenue guidance for the 4th quarter, We're now assuming that approximately $12,000,000 of existing customers' renewals will convert to SaaS in Q4, which is up from $10,000,000 previous. In the 3rd quarter ARR grew 16% year over year The $517,500,000 year to date, we generated $46,000,000 of free cash flow, which was up From $800,000 over the same period last year, reflecting the inherent leverage in our model as well as our commitment to balancing top line growth with improving cash flow generation. In Q3, We continue to see a macro environment that was similar to the first half of the year.

Speaker 2

We're still seeing deal scrutiny and longer sales cycles We expect these longer deal cycles to continue along with the associated budgetary scrutiny and our updated guidance takes this Turning now to our Q3 results in more detail. Before I get into the numbers, Let me remind you of what we've said for a while now. ARR free cash flow and ARR contribution margins are the leading indicators for this transition. We take our commitments to TheStreet seriously and our revenue guidance is based on a combination of our expected SaaS mix And existing customer conversion. As we said previously, the faster we progress throughout the transition, the more headwinds we will experience to our traditional income statement metric.

Speaker 2

We view these headwinds in a positive light as they show our customers are adopting our SaaS solution more rapidly. Q3 total revenues were $122,300,000 down 1% year over year. During the quarter, as compared to the same quarter last year, we had approximately a 12% headwind to our year over year revenue growth rate As a result of having increased SaaS sales in our booking mix, which are recognized ratably versus the upfront recognition of our on prem subscription product. Subscription revenues were $97,700,000 and maintenance and service Revenues were $24,600,000 as our renewal rates were again over 90%. Moving down the income statement, I'll be discussing non GAAP results going forward.

Speaker 2

Gross profit for the 3rd quarter $106,700,000 representing a gross margin of 87.3% compared to 88.3% in the Q3 of 2022 despite significant revenue headwinds, which were largely offset by greater efficiencies On our SaaS platform than we initially expected, operating expenses in the 3rd quarter totaled $101,900,000 As a result, 3rd quarter operating income was $4,900,000 or an operating margin of 4%. This compares to operating income of $9,800,000 or an operating margin of 7.9% in the same period last year. During the quarter, as compared to the same quarter last year, we had approximately an 11% headwind to our operating margin As a result of having increased SaaS sales in our booking mix, which are recognized fully ratable versus the upfront recognition of our on prem 3rd quarter ARR contribution margin was 11.1%, up from 3.6% last year. The significant leverage improvement even during the early stages of the transition reflects our ability to drive strong incremental margin While growing ARR and transitioning to SaaS. During the quarter, we had financial income of approximately $8,000,000 driven primarily by interest income on our cash, deposits and investments in marketable securities.

Speaker 2

Net Income for the Q3 of 2023 was $10,400,000 or $0.08 per diluted share Compared to a net income of $6,700,000 or net income of $0.05 per diluted share for the Q3 of 2022. This is based on 126,700,000 diluted shares outstanding and 126,900,000 diluted shares outstanding For Q3 2023 and Q3 2022 respectively. As of September 30, 2023, We had $731,500,000 in cash, cash equivalents, short term deposits and marketable securities. For the 9 months ended September 30, 2023, we generated $49,000,000 of cash from operations compared to $8,400,000 generated in the same period last year. And CapEx was $2,900,000 compared to $7,600,000 last year.

Speaker 2

During the Q3, we repurchased 1,200,000 shares At an average purchase price of $30.10 which completed our intended share repurchases. Over the course of the program, We repurchased approximately 4,400,000 shares at an average purchase price of $22.64 For a total consideration of approximately $100,000,000 Turning to our guidance in more detail. We're raising our full year SaaS mix of new business and upsell ARR guidance to 55%, up from 50% previously and we expect Q4's SaaS mix to be 60%. We continue to take a prudent approach in building our SaaS mix outlook as the dollar value of deals we expect to close in the Q4 is the largest of the year, which is in line with historical trends. In Q4, we're assuming that $12,000,000 of renewal We'll convert to SaaS, which will serve as a headwind to revenue.

Speaker 2

Conversions to SaaS Before considering any uplifted deal sizes do not impact ARR, our guidance continues to factor in The same level of macro headwind that we've discussed at length in the past. Now turning to our guidance. For the Q4 of 2023, we expect total revenues of $115,000,000 to $154,000,000 representing growth of 5% to 8%, non GAAP operating income of $25,000,000 to $27,000,000 And non GAAP net income per diluted share in the range of $0.22 to $0.24 This assumes 126,100,000 diluted shares outstanding. For the full year 2023, we now expect ARR of $535,000,000 to $539,000,000 representing growth of 15% to 16% Free cash flow of $40,000,000 to $45,000,000 which includes $8,000,000 to $10,000,000 Headwinds related to the TCJA Capitalization of R and D Provisions. Total revenues of 4.95 $26,500,000 to $28,500,000 non GAAP net income per diluted share In the range of $0.31 to $0.33 This assumes 126,600,000 diluted shares outstanding.

Speaker 2

In summary, we continue to see solid demand for both new and existing customers who wish to consume Varonis through our SaaS platform. As a result, our transition continues to move quickly and approximately 15% of our total ARR is now coming from SaaS. This is benefiting our ARR performance and cash flow generation, which positions us for a strong Q4. With that, we will be happy to take questions. Operator?

Operator

Thank you. Thank you. Our first question comes from the line of Saket Kalia with Barclays. Please proceed with your question.

Speaker 3

Okay, great. Hey, guys. Thanks for taking my question here and just want to send our thoughts to the Varonis team and their families in Israel.

Speaker 2

Thank you. Thank you.

Speaker 3

Absolutely. If I stick to one question, maybe I'll make it for you here, Yaki, it just seems like great traction on SaaS. For those customers that are moving to your SaaS tools, What are you seeing on usage of the different modules? Are you seeing any change in usage now that the tools are arguably easier to deploy And use.

Speaker 1

We see just a dramatic change. We see what we call the robotic value proposition. And the North Star was always what we call 10% of the effort, order of magnitude more value and this works according to plan. We can measure everything from installation to update to remediation, our ability to do threats. And the other thing, we also build the ability of Our people, our professional services to support the customer is much more ease.

Speaker 1

We can provide a lot of the value of the platform with the customer almost doing nothing, just very, very little in helping in terms of So just completely different value proposition, literally unleashing robots to solve the problem.

Speaker 3

Got it. Very helpful. I'll get back in queue. Thank you.

Operator

Our next question comes from the line of Hamzah Karawala with Morgan Stanley, please proceed with your question.

Speaker 4

Hey, good evening. Thank you for taking my question. Yaki, I wanted to dig in a little bit more about your commentary around generative AI. I think a lot of the CIOs and CISOs that we're Talking to more recently are talking about our data security and governance is a big hurdle to deploying these large language models. And I'm curious To what extent, are you starting to have conversations with customers on how they can play these generative AI models In a way that can prevent things like data leakage or poisoning from occurring?

Speaker 1

I think that it's going to be a Complete game changer. Reality is that we still haven't seen it completely, but just the initial release of This is not me saying, Microsoft are saying that 90% of the access controls are excessive. You don't need them. So you have these Tools that leveraging large language models that going in mining massive amounts of data, Creating a tremendous rate, high value information products that are completely out of policy. So now think about it, if I take your credentials and 90% of the data you can access is not relevant for you And you have these AI tools that are extremely sophisticated that creating this highly A valuable data.

Speaker 1

I just think that very soon what you will see is that organizations understand that they need to make sure that they have access Control a data auditing and classification in place in order to make sure they can realize productivity gains and avoid disaster. So this is something that we're starting to see that customers are talking about it, that all the customers are talking about it. And I really believe that Varonis

Speaker 4

Thank you.

Operator

Our next question comes from the line of Matt Hedberg with RBC TC Capital, please proceed with your question.

Speaker 3

Well, thanks guys. Congrats on the results and we send our thoughts and prayers To all the Burrows employees around the globe and Israel. Yaki,

Speaker 2

maybe as a

Speaker 3

follow-up to Hamzah's question, I think in the prepared remarks, you said you don't expect to sell a separate GenAI SKU at this point. I'm curious, could that change in the future? And then maybe second As you're having these initial conversations with customers,

Speaker 1

how do

Speaker 3

you think it could impact deal sizes longer term?

Speaker 1

So, yes, it's definitely it can change. If you think what we are doing with our AI, one thing is that you We use the product with just natural language, which means that you don't need to learn syntax, which is tremendous. The second thing, really, if you look at the metadata that we are collecting, we are the only company in the world that has this metadata, what we call a Data oriented threat detection and response and you can take a regular IT person and he has now have the assistant to be world class Threat detection person. But with time, maybe we'll monetize it, but It's for us the best way to monetize is to sell the platform and this is really answering your the other part of your question. Initial deal is great, but I really think that the way that we can grow ARR within our customer base, I think that It's significant and what we are seeing now is just the people of the iceberg.

Speaker 1

We're starting to have stability in the overall transition It's a completely different usage, able to leverage the unique data that we have to have AI being the foundation for really the digital world To make sure that can be prepared and benefit AI in a secure way and then we'll decide if we are going to monetize this model. But at this point, we want to make Sure that we have so much to say to our customer that it will be very easy for them to use it and to gain value. Thanks, Yaki.

Operator

Our next question comes from the line of Brian Essex with JPMorgan. Please proceed with your question.

Speaker 2

Hi, good afternoon. Thank you for taking the question and our thoughts are with you and your families in Israel as well. Hey, just wanted to dig in a little bit towards maybe for Yaki, what you're seeing in the pipeline, particularly with regard to Previous commentary reflecting elongated sales cycles and the impact of deals in slight as you or as those customers assess moving to SaaS instead of term. Maybe if you can help us understand the impact in the quarter and then how much visibility into the pipeline? What was growth like and how much confidence that gives you into your ability to execute In the last quarter of the year here.

Speaker 1

We see very healthy pipeline across the board. And the other thing that we're starting to see is Organizations understand that data protection is inevitable. It's actually your first frontier and your last freezer. If you don't protect data, whatever you will it will never be protected. And if everything else that you are doing will fail, it's the only thing that will save you.

Speaker 1

And I also think that many organizations Didn't attack it heads on because it was hard to do. And with the robotic value proposition That we are building, they understand that they can do it and if you look at the enterprise projects, they can gain immediate time to ongoing value in a completely automated way. So I just think that I'm spending a lot, a lot of time with customers these days, and I definitely see that people understand that they need a Sophisticated data security platforms and the only way that they can do it is automation and we are very well positioned to take these budgets. Got it.

Operator

Our next question comes from the line of Joel Spine with Truist. Please proceed with your question.

Speaker 5

Thanks for taking my question. And I'm also thoughts and prayers with all of you. I wanted to just follow-up on these new SEC reporting rules. And if you are seeing it, Your customers are starting to ask questions about them and also is that as a potential driver to your pipeline and new business?

Speaker 1

It's definitely a potential driver. What we see all around is that people understand that they need to protect data. I think that in the last few years, organizations spend a fortune on security and a lot of them get Not such great return on investment. You have a lot, a lot of security around the perimeter. And at the end of the day, if you will dissect So most breaches, all they are happening from an insider that is a user or someone stole a credential and acting like a user And really inflicting the damage on the data stores.

Speaker 1

Attacks can come from anywhere and any device, but only going in one direction. And it's the data that essentially the most valuable assets that most organizations have and the most vulnerable one. So the SEC regulation is just another one, just inevitable. You want to have cybersecurity, you need to protect data. So this is really where we are and what we see.

Speaker 1

And definitely, every regulation is open. Thank you.

Operator

Our next question comes from the line of Roger Boyd with UBS. Please proceed with your question.

Speaker 6

Great. Thanks for taking the question and congrats on another very strong quarter of SaaS adoption. I don't think investors should be too surprised Severonis outperforming on a transition timeline. But just given the success you're seeing with SaaS and the meaningful outperformance on mix expectations and conversions, any How you're thinking about the timing of Phase 2 of the transition? And why not lean further into a more active plan that convert existing customers?

Speaker 6

Thanks.

Speaker 2

I think that question can be broken into 2. 1 is the overall timeline and the second part is Phase 2. When we think about kind of the overall timeline, I think with a 5% SaaS increase versus last quarter, When you think about that math and kind of the way it extrapolates going forward, it definitely makes sense To reconsider our timeline and that's something that we talked about last quarter that we would revisit our guidance for that at year end And we plan to do that. I think overall, when you think about the transition, it's moving very fast. We're very happy to have 15% of our ARR coming from SaaS in just three quarters.

Speaker 2

It's happening fast because our customers and our sales force are adopting it Very, very positively. So we definitely look forward to providing more color on that part in our next earnings call. In terms of Phase 2, When you think about kind of the conversion of the installed base and that's how we define Phase 2, it hasn't begun yet. But we are increasing the number that we expect in terms of conversion in Q4 to 12,000,000 And that's going up from $10,000,000 that we guided last quarter. And when you think about the Q3 number, we actually came in at $10,000,000 Which is a really high number as you think about it and it's very positive, but still a very small percentage of our existing customer base.

Speaker 2

So as much as we're seeing very strong adoption that's happening in a natural way, we haven't prioritized it yet, but we plan to do that next year. So I think overall, As we look at the progression of the transition, it's been really positive and we hope to continue to move in that pace going forward.

Speaker 1

Thanks, Guy.

Operator

Our next question comes from the line of Andrew Nowinski With Wells Fargo, please proceed with your question.

Speaker 7

Okay. Thank you for taking the question. I think last quarter your guidance was for SaaS to account for about 45% of that new and upsell business because of the Expected contribution from the U. S. Federal deals.

Speaker 7

So I guess given how much higher SaaS was relative to your guidance this quarter, is it fair to assume that the Fed demand was Not as strong as you expected. And if so, what happened to those deals? Thanks.

Speaker 2

So the growth driver this quarter was overall the enterprise business. And when you

Speaker 1

look at the

Speaker 2

59%, it was driven by the enterprise business. It's a strong reflection of How customers in the enterprise business are adopting SaaS. When you look at the federal industry as a whole, We definitely see the opportunity there, but it's still small, mid single digit percentages out of ARR. But when we look at the opportunity, we feel very confident about our ability to grow there.

Operator

Our next question comes from the line of Fatima Boolani with Citi, please proceed with your question.

Speaker 8

Good afternoon for taking my questions and our prayers are with you

Speaker 1

and the

Speaker 8

entire employee base In the conflict zone. Yaki, a question for you, a bigger picture one actually. We've been hearing a lot about data protection, Data security posture management and sort of all these new monitors that are coming up as well as more traditional backup and 3 vendors on the infrastructure side talk a lot about the importance of data protection and data recovery. I wanted to get your perspective on How you are interfacing with buyers as buying psychology changes around data protection? I wanted to get your How those conversations are changing for you, if at all, and if these sort of changes in the competitive landscape Are benefiting you in a way in providing a spotlight to what you've been saying all along with respect to the importance of data protection?

Speaker 1

I think that we just don't see the backup and business continuity in data protection. We are much more on data security. And but it's just people understand that they need to protect valuable data. Regarding posture management and all of this stuff, I think that the organization understands very well that this is the first time that we are benefiting from other people doing marketing. And in order to solve the problem, you really need these 3 use cases and you need the metadata and something that is very hard to do.

Speaker 1

And everything really eventually in order to solve the problem need to be under one umbrella of the data security platform. You think it's most breaches, people are doing this lateral movement Between data stores and you need to enrich the data. So we definitely see that the marketplace understand that they need One big platform, you need to be able to classify in one place and then all repository to do it at scale To have the profile of how people and identities are using data and to be able to do remediation in a very Reliable automated way. So we definitely see that everything that is happening in the ecosystem benefiting us and we are Very excited to have a tailwind from the marketing that other vendors do.

Operator

Our next question comes from the line of Chad Bennett with Craig Hallum. Please proceed with your question.

Speaker 3

Great. Thanks for taking my question. So just on I know it's early, but just in terms of Kind of the type of customer converting from on prem subscription to SaaS, I think you've talked before about that 25% to 30% uplift, but and I think you gave a couple of examples on the call already. But is there any commonality in terms of where the on prem subscription customer is in their license journey, when they're converting? And is there are you seeing significant cross sell, up sell on that conversion from a license standpoint?

Speaker 3

Or is the hope, obviously, like a lot of conversion stories that once you get them to SaaS, like for like product, That whole cross sell, up sell just becomes easier and kind of accelerated?

Speaker 2

I think that's a very good question. And when you well, I'll start by saying that the SaaS Offering is so much better for our customers, but it's a no brainer for them and we're seeing that with the amount of conversions that are happening in a natural way. When conversions happen, we can get an uplift in the number of licenses that they buy because we're selling the platform. They don't have the opportunity to buy individual licenses. We can get an uplift in the fact that the number of users goes up And we can get an uplift in their ability to consume more of the product.

Speaker 2

It really depends on the situation of the customer, Where they are in terms of the renewal, whether they want to speed it up and or wait for the actual renewal date to come to place. So it's very individual, but at the end of the day, once we get them to the SaaS offering, their ability to see value And the simplicity of the usage of the product gives us a tremendous opportunity to continue to sell them more and more licenses. So, I would say there's no one straight answer on how it happens, but at the end of the day, it just works in our favor to get them to SaaS With good confidence in our pricing methodology as we see it so far.

Operator

Our next question comes from the line of Rob Owens with Piper Sandler. Please proceed with your question.

Speaker 6

Great. Thank you for taking my question. I was curious if you could comment on just what the channel response has been regarding the move to SaaS? And Are you getting the breadth of channel participation that you would hope in new transactions? Thanks.

Speaker 1

Yes. It's the channel reaction is usually just a direct correlation to The customer reaction, so definitely they understand that it's much easier to sell. And it requires significantly less professional services and this is something that they will need to adapt to. We just see The whole thing of this platform is a tremendous automation, but we're definitely getting a lot of help with the channel to take this platform tomorrow.

Operator

Our next question comes from the line of Jason Ader with William Blair. Please proceed with your question.

Speaker 5

Yes. Hi, guys. I wanted to ask you on firstly first a clarification. You said a 12% headwind to revenue growth in Q3, I believe. That's 12 percentage points, correct?

Speaker 1

Correct.

Speaker 5

Okay. And then, just on the kind of following up on the channel question. Can you remind us how you go to market? How much is direct? How much is indirect?

Speaker 5

And then where are you seeing the most success right now in terms of finding new customers?

Speaker 2

So we sell 100% through channel, but our outside sales force Really does all of the heavy lifting of doing the risk assessment, talking to the customers, explaining where the risks are. So the channel helps us in getting the meeting And they help us in closing the deal, but all the hard work in between is done by our outside sales force. When we look at the opportunity With our SaaS offering, it opens up new markets, it opens up new territories, it opens up new industries to Basically, new customer opportunities that we didn't have before. And all of the reception that we have To date, the seed on the SaaS offering has been positive, and we expect that to continue as we kind of really went through the toughest part of the transition, Kind of clearing through the pipeline and now introducing every new customer with a quote that is SaaS only They're not really on prem subscription as we had in the past. So I think overall, we're very well positioned to take advantage of that opportunity going forward.

Operator

Our next question comes from the line of Joseph Gallo with Jefferies. Please proceed with your question.

Speaker 3

Hey, guys. Thanks for the question. And appreciate the AI commentary. You guys have a large M365 footprint. Can you just give us an updated size and growth profile of that business?

Speaker 3

And then maybe just to be clear, given the rollout of Copilot this week, Does your existing solution capture that opportunity now? Or is it more just that you guys are perfectly positioned to capture that opportunity long term?

Speaker 1

Thanks. Regarding the product, in terms of the to preparing an organization for AI, it's already here. So it's just the basic robotics value proposition, understand where data is critical, make sure that only the right people can access the right data, I know you can stop any abnormal behavior. It's the basics. Without it, you can't use it in a secure way, and this is 100% us.

Speaker 2

Just to touch on the first part of the question, when we look at the Office 365 contribution, It's definitely become a significant tailwind for us going forward. If you go back to our Investor Day in March, We actually showed in one of the slides there that our penetration within the overall 365 opportunity was At the time in March, it was 1%. Hasn't grown too much since then. So when you think about the opportunity going forward, There's so much for us to capitalize on, and we see the reception of our customers very positive when we sell that license.

Operator

Our next question comes from the line of Rudy Kessinger with D. A. Davidson. Please proceed with your

Speaker 3

Hey, great. Thanks for taking my question. Guy, what was SaaS as a percentage of the mix if you exclude federal In Q3? And then just how much higher is federal as a percentage of new and upsell ARR in Q3 relative to Q4 and the other

Speaker 2

So like I said before, the actual driver this quarter was the enterprise business And that's really what drove the 59%. To remind you, we're not FedRAMP certified yet. So we didn't have SaaS sales that were sold under the federal business, but we do expect to have FedRAMP For next year's cycle, which can become a significant opportunity for us, and when you think At the overall opportunity from a new business and an upsell in that market, we fit, like a glove to that type of use case. The amount of malicious actors that have happened only in the last couple of months has been tremendous and our product sits there very, very nicely. And we feel that we can capitalize on that opportunity and grow our ARR coming from that industry going forward.

Operator

Our next question comes from the line of Joshua Tilton with Wolfe Research. Please proceed with your question.

Speaker 9

Hey guys, thanks for sneaking me in. And I'll just say my thoughts and prayers with your employees and just all the people of Israel. I'm actually going to sneak in 2.5 questions really quickly. My first question is just how should we think about the implied Q4 net new ARR Seasonality and are the macro impacts baked into 4Q worse than they were a quarter ago? And on the AI front, which is my second question, Why will Microsoft offer these capabilities?

Speaker 9

And if so, do you expect this to bring you into more competition with them going forward?

Speaker 1

So in terms of Microsoft, we are the only truly company in the world today that Taking the 3 streams of metadata, the permissions, the content and the activity to build these robots for right size access. So we just need to build completely different type of solutions in order to do that. So I just think that we can, for a long time, leverage our moat and maintain a tremendous competitive advantage in this space.

Speaker 2

And when we kind of think about the guidance, our philosophy hasn't changed. So we're definitely thinking about the guidance in the same way that we've talked about it throughout the year. I think in terms of where we are in Q3, we definitely saw things stabilize Compared to previous quarters, and that's a good sign for us. But our assumptions in terms of guidance have stayed the same. And we think that we are set up well for having our large Q4 in terms of seasonality.

Speaker 2

We don't see any change Compared to the on prem subscription, so SaaS should be the largest quarter. Q4 should continue to be the largest quarter of the year as it has been In previous years, obviously, from a revenue recognition perspective, it does change because it's ratable. But you've heard me Talked millions of times about the fact that ARR, free cash flow and ARR contribution margins are the right metrics for this transition. And especially in Q4, they should be viewed as the leading indicators of the business.

Operator

Our next question comes from the line of Shelby Sarrafi with FBN Securities. Please proceed with your question.

Speaker 6

Yes. Thank you. So your headcount really was flattish in terms of growth in Q1 and Q2. And it looks like it grew around 50, Which is a decent pace for the first time in like a year. So my question is, is this a sign that The environment is better for you.

Speaker 6

You talked about deal scrutiny, etcetera, but at least is it better And therefore, you're hiring more. And related to this, talk about your headcount growth expectations going forward.

Speaker 1

We know how to do this transition, And it was very important for us when we did it just to be focused on just the right moving parts to make sure that it will work. We definitely see Just more stability in the transitions and despite of the economic headwinds, we definitely see that there is just Inevitable demand for data security, this is something that the organization's need and we have A lot of pipeline in what we can do in terms of say roadmap of features and products Massive total available market, so we need to cover it with sales force and make sure that our customers succeed and we keep building their organization. So the business is performing and we are investing against a massive opportunity.

Speaker 2

And If you go back to our last quarter's earning call, you could hear in the commentary that we talked about the fact that we're hiring. So obviously, the fact that we grew the headcount was part of our planning. We want to continue To increase the headcount, but we obviously want to do it in the right way and we want to make sure that we generate increased productivity And I think we can do that going forward. So it's a balancing act of increasing headcount at the right pace, In the right positions, in the right locations, but also improving our leverage as we have done When you look at kind of the fact that the ARR contribution margin is now 11.1%, an increase of 7 50 basis points year over year, Which is pretty

Operator

significant. Our next question comes from the line of Shrink Kothari with Robert W. Baird. Please proceed with your question.

Speaker 10

Hey, thanks for taking my question. Again, Thoughts and prayers to our entire team out there. Just a follow-up to the previous Microsoft question. I know Yaki, you mentioned the tailwinds and the growth runway in implementing the access controls and governing policies. And there was a previous question on the competitive advantage versus Microsoft as well.

Speaker 10

Just Just trying to understand, of course, as the significance of data security rises, as you just pointed out, and especially in the realm of generative AI, Which where you're anticipating kind of more traction, particularly for data access governance. Is it the right way to think that Varonis Kind of focusing on a comprehensive data protection platform, including data security, access control, governance versus what Microsoft is offering, Just got a more narrow kind of DLP and this urgency around data security and Of course, with respect to the data protection tailwinds, like is this the competitive advantage that you guys have? And is that the right way to think about The competitive dynamic from your perspective, I have a quick follow-up there as well.

Speaker 1

Yes. It's essentially completely different, what we just giving you automated outcomes regarding this access Control classification and threat detection. We have very little features that overlap And a lot of very good synergy to work with the way that they can label for DLP, as you mentioned, and other stuff And they're and but it's different. We actually work very well with them and we have a very good partnership Regarding generative AI, which is the foundation, the building block, if you want to use generative AI in the I2A In order to introduce a lot of risk and can end up in disaster, you need to use our solution to make sure that you are ready. So this is except of all the AI features that we can deliver Using technologies like large language models, we are the foundation to make sure that businesses can use it in order to extract value from their deal.

Operator

Our next question comes from the line of Hugh Cunningham with TD Cowen. Please proceed with your question.

Speaker 11

Hey, guys. Thank you for taking my call. And I'll echo that everyone here on our team, Our thoughts and prayers are with you and your families, your friends and your coworkers there for Otis.

Speaker 2

Thank you. I

Speaker 11

do have 2 quick ones. The first one is the 25% to 30% uplift that we're talking about, that's just On pricing of subscription versus SaaS, that doesn't include any assumptions that you mentioned before, More licenses, users go up, anything like that?

Speaker 2

Apples to apples only. So yes.

Speaker 11

Okay. And then these conversions of existing customers, are these taking place at the end of their existing Contracts, what I'm trying to figure out here is if when you quote a number $10,000,000 or 12,000,000 That number includes a sort of accelerated recognition for the initial period in that subscription. Is that right?

Speaker 2

No. That relates only to the deals within the quarter.

Speaker 1

Okay.

Operator

Our next question comes from the line of Brian Colley with Stephens, please proceed with your question.

Speaker 12

Hi, guys. Thanks for taking my question here. Can you talk about how The SaaS platform has impacted the pipeline for new logos as well as sales cycles for those new customers. I'm just Curious if you're seeing an acceleration in new logo ads or sales cycles?

Speaker 2

So I can tell you when we look at the new customer adds, we've definitely seen positive signs this quarter. And I think that as we look at our ability to sell SaaS to new customers, as I said in one of my previous answers before, It opens up opportunities that we didn't have before with the on prem subscription. So I think overall, the signs that we're seeing are healthy and positive And definitely gives us the ability to show value. I said before, we're kind of past this Challenging part of the transition where we had to clean clean through the pipeline where some of the quotes were introduced To customers in the past as on prem subscription, now we're just starting with the SaaS as part of the quote and It's been very well received by customers because the value of the RSaaS product is much greater than the on prem subscription.

Operator

That's the end of our Q and A session. I'd like to hand it back to management for closing remarks.

Speaker 3

Thanks for your interest in Varonis. Look forward

Operator

to meeting you all at our conferences this quarter. Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time and have a wonderful day.

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Key Takeaways

  • Varonis’ SaaS transition accelerated in Q3 with a 59% SaaS mix vs 45% guidance, driving SaaS ARR to ~15% of total and overall ARR of $517.5 M (+16% y/y), while YTD free cash flow jumped to $46 M from $0.8 M.
  • Executives highlighted generative AI as both a risk and opportunity, unveiling new AI SOC and natural language search capabilities in the SaaS Data Security Platform to automate threat investigations and boost analyst efficiency.
  • The “robotic value proposition” of Varonis SaaS—automated remediation, proactive incident response, faster deployment and lower infrastructure cost—has shortened sales cycles, enlarged initial deals and improved margins.
  • Major customers—including a large state government and a multinational financial institution—migrated from on-prem to Varonis SaaS for enterprise-wide data protection across Windows and Microsoft 365, expanding coverage and scalability.
  • Q4 guidance projects a 60% SaaS mix and 5–8% revenue growth, while full-year 2023 ARR is forecast at $535–539 M (+15–16% y/y) with free cash flow of $40–45 M.
AI Generated. May Contain Errors.
Earnings Conference Call
Varonis Systems Q3 2023
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